British debt market factors in rate hikes

Inflation fears boosted by record May PPI rise

By

WilliamL. Watts

LONDON (MarketWatch) -- A record jump in wholesale inflation saw British credit markets factor in the possibility of rate hikes by the Bank of England in coming months despite fears of a major economic slowdown.

The price of goods leaving British factories rose at an annual rate of 8.9% in May, the largest jump since the current statistical series began in 1986, the U.K. Office for National Statistics said Monday. On a monthly basis, the output price index rose 1.6% between April and May.

The figures were well above consensus expectations for a 0.7% monthly rise and a 7.9% year-on-year gain, according to a survey of economists by Dow Jones Newswires.

The news roiled interest-rate markets, with yields on two-year government notes soaring as prices tumbled. The yield on the two-year government note rose 33 basis points to 5.37%, according to FactSet. The yield on the 10-year government bond, or gilt, rose by around 15 basis points to 5.12%. Bond yields and prices move inversely.

Meanwhile, the front end of the sterling interest rate markets also saw a sharp selloff.

"The interest-rate situation in the U.K. is best described as carnage," said Philip Shaw, strategist at Investec Securities. "U.K. interest rate markets are panicking now."

Two-year swap rates rose by around 30 basis points from Friday's close, according to Citi. U.K. rate markets now price in the possibility of three rate hikes by the end of the year.

"A toxic mix of factors seem to be behind today's sharp sell off, with position unwinding, today's strong producer price data, worries that the MPC may sympathize with the ECB's hawkish comments from last week, and the further surge in oil prices of Thursday and Friday," wrote Michael Saunders, chief U.K. economist at Citi.

'The interest-rate situation in the U.K. is best described as carnage. U.K. interest rate markets are panicking now.'
Philip Shaw, Investec Securities.

Saunders and other economists said the Monetary Policy Committee is indeed unlikely to ease rates in the face of surging inflation pressures stemming from surging commodity prices and a weak pound, but also appears unlikely to hike rates either.

"The economy is slowing sharply and likely to weaken further in response to the credit crunch, housing weakness, and the erosion of real incomes from strong inflation," Saunders wrote.

In fact, the recent sharp rise in market interest rates will likely feed through to put more upward pressure on fixed mortgage rates in coming weeks, further contributing to the plunge in housing activity and the overall economic slowdown, he said.

While food and energy costs played a big role in the price surge, they weren't the sole factor, the data showed. The core output rate, which excludes food, beverages, tobacco and petroleum rose 5.9% in the year to May with a 1.2% monthly rise.

As was widely expected, the Bank of England's Monetary Policy Committee last week stood pat at its monthly meeting, leaving its key interest rate unchanged at 5%. Economists scaled back expectations for further rate cuts after last month's BOE quarterly inflation report showed the bank expects consumer inflation, which hit 3% in April, to rise further and remain well above its 2% target well into 2009. See full story.

"Today's data confirm the inflation concerns expressed by the Bank of England at last week's interest rate meeting," said Joerg Radeke, an economist at the Center for Economic and Business Research.

"Worryingly, climbing input prices indicate that output prices will rise further in the short and medium term. Of particular concern is that core producer price inflation, which, importantly, excludes the direct impact of oil prices, [seemed] to pick up pace," he said.

Input prices soared 27.9% on the year in May and jumping 3.5% on a monthly basis, driven largely by surging crude oil prices. Excluding food, drinks, tobacco and oil, input prices still rose 13.8% in May, the ONS said.

"The increasing split between input and output prices suggests that corporate profits will come under pressure at the some moment when pricing power declines due to the weakening economy," wrote strategists at BNP Paribas. "In the near-term, rising inflation data suggest sterling will rally due to upwardly adjusted rate differentials."

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